Which Rate to cut? Financial Express: 1st November 2008

The CRR and repo rate are two instruments used by the RBI to control growth in money supply. How does one choose between the two and which is the superior tool? This is important in the current scenario where there are phases of low and high liquidity in a scene where interest rates are still sticky.
The CRR impounds/releases cash from banks which reduces/increases their scope to lend thus controlling the money multiplier. The resources impounded earn no interest either in the form of a loan disbursed or a token rate paid by the RBI. This in a way impacts the profitability of banks as interest is being paid without any commensurate income being earned.
In case of the repo (or reverse repo) the RBI changes the interest rate at which banks deal with it. Therefore, to the extent that banks are lending or borrowing from the RBI, the rate change will affect their cost of borrowing which should logically get translated into their interest rate structure. But the efficacy of the rate hike depends on the quantity of money that the banks are borrowing. If banks expect a liquidity crunch then they would revise their basic rates, but if the liquidity situation is expected to be relatively easy, then status quo may prevail. Today a number of banks are offering high rates for 3 years, which means that either there is a mismatch in assets and liabilities or that they would like to lock into such rates for a longer term as the tenure of their assets would be lengthened.
Now, in the current situation, their relative costs could be evaluated. A CRR increase of say 50 bps would mean the impounding of Rs 20,000 crore. As banks would not be receiving any income on these funds, and would be paying an average deposit rate of say 6%, the direct loss would be Rs 1,200 crore, for the entire year. This is intractable unless the CRR is reversed, in which case the gain would be say 200 bps over the deposit rate, or Rs 400 cr. In case of the repo rate, if it is hiked by say 50 bps, then assuming that the banking industry borrows Rs 20,000 cr from the RBI on a daily basis (which never happens since there is an equal spread of borrowings and lending from the RBI throughout the year), then the loss would be Rs 100 crore. Further, banks may choose to rework their interest rates across the board and actually cover up for this higher interest rate. Therefore, they would be better off with a repo rate hike compared with the CRR hike.
The impact on the investment portfolio in terms of losses booked would be the same in both cases as yields on GSecs and bond prices fall when the mark to market valuation is done as interest rates increase.
So, which is the superior tool? CRR is superior when the idea is to curb the lending ability which was the objective when there were large forex inflows which led to monetisation. However, when liquidity is tight, and there is need to restrict growth in credit, then a repo rate is preferable.
An interesting analogy that can be drawn here is with the foreign trade sector, where tariffs are more efficient than quotas. CRR is like a quota while interest rates are like tariffs. Quotas are inefficient as they tamper with the market mechanism, but are effective if the purpose is to physically limit the quantity of funds in the market. Interest rates like tariffs only move the acceptable price schedules laterally. This may not serve the purpose of say increasing interest rates like those on deposits or loans, but then the choice is with the bank to absorb this higher cost.
Therefore, ideally the CRR must be used only when there are excess/shortage funds in the market. The repo rates must be the main tool to control monetary growth. A way out for the RBI is to fix these rates every month based on the state of liquidity. This will address the concern of liquidity changing periodically. As a rule price adjustments should be preferred to quantitative restrictions for the system to be efficient, and the latter should be tinkered with only in case of extreme liquidity situations.

Monetary Signals ahead: Financial Express: 19th October 2008

RBI's action of reducing the CRR in three tranches from 9% to 6.5% is a clear indication of a system of changing paradigms that has been in vogue throughout the year. One will recollect that the RBI started the financial year with a series of increases in the CRR from 7.5% to 9% as many as 6 times between April 26 and August 30. The reason then ostensibly was that inflation was a concern and there was pressure to control the rate of growth of price increase. At that time, critics felt that inflation was a cost-push phenomenon and that removing liquidity from the system would not really help as long as the supply constraints remained. However, it was justified on the belief that potential demand-pull forces would be controlled through these measures and would address the broader issue of inflationary expectations. In a way it did not matter, as it was the traditional slack season when the demand for funds is low.
The policy of increasing the CRR and curbing liquidity however, had certain unintended effects in terms of the negative impulses seen on industrial growth. which has come down to less than 2% in August, which is now a concern. Projections for the same are less than sanguine, between 6-7%, now following the financial crisis from the number of 8-9% expected earlier. Also, inflation per se has not really been moderated and is only gradually coming down from the level of 12%, as supply fundamentals have improved. RBI is of course carefully tracking this variable before posting a comment on whether or not the worst of inflation is behind us. It may be waiting for the declining trend to continue before passing a firm judgment.
Now, the global crisis has exacerbated the situation, forcing RBI to lower the CRR to 6.5%. The trace of urgency is palpable because the three reductions have been with effect from the same date: October 11, as the crisis has intensified. There was a deficit of Rs 90,000 crore in the system as evidenced from the borrowings through repos in the market, which could not be covered by the 50 bps or the 150 bps reductions to begin with, which prompted the third round cut of 100 bps. The overall attempt to increase liquidity through reimbursements of farm waivers, opening the window for mutual funds, etc, are all targeted at making life morecomfortable. There are now hopes based on the u-turn of RBI that the repo rate will also be reduced going ahead.
Now, there are two issues, which come to the forefront. The first is that we have tacitly accepted that growth will now be more important than inflation and that the monetary policy in particular will be geared in this direction. This in turn makes the overall approach to policy fairly fickle, as the three reductions were in a span of just a little over a week. This phased reduction has now sort of matched the deficit that has come up in the system. The fact that we are now going to focus on growth means that inflation is not a worry. But, what if inflation starts rising again? This will become a delicate issue because by lowering rates at this time to spur growth, higher demand, especially from investment, could lead to the problem of lags and leads, which can be painful in terms of higher inflation in the interim period. What would be the approach then? We may have to restart increasing the CRR and repo rates again.
The second issue is that theoretically we need to be more sure of the use of the monetary policy. The Rational Expectations Theory propounded by Lucas and Sergeant would advocate strict targeting of money supply and rates by the monetary authority and silence there onwards. The markets are smart enough and efficient to take the cue and make the required adjustments. However, this year, probably on account of certain compulsions, the CRR was increased when inflation was high. And now that we are used to a high inflation number, the rates are being lowered to spur growth. The market gets confused signals about the monetary stance, which paradoxically provides scope for the monetary policy to be effective.
This kind of excessive fine tuning, though theoretically sound, does send mixed signals and a statement from RBI regarding its focus would actually guide the markets, as the present measures may only provide solace of affirmative action being taken. We have already lost out on growth by raising the rates and run the risk of having the double-digit inflation rate follow us till March. Industrial growth could get sliced down by 2% points, as banks have decided not to reduce rates as yet. Maybe they are waiting for the repo rate cut now. We are now banking on the kharif harvest and falling oil prices; as also the declining metal prices, following lower demand on account of the global slowdown, to provide comfort on the inflation numbers. However, we may still have to fall back on the supply factors for relief in inflation, as the present relaxation in CRR has the potential to stoke demand side factors. The rest of the year is surely going to be a challenging one.

How Safe are our Banks: October 25th 2008: DNA

The only way to ensure secure banking is to have strong prudential practices in place
The US government’s decision to take stake in the private institutions following the financial crisis has been interpreted as a move towards nationalisation. This, it has been said, is a clear vindication of the view that capitalism in the current form delivers greed under the veil of efficiency. India, fortunately has not been affected because we were conservative, and probably wiser, on hindsight. Is this feeling of security really justified or is it misplaced?
The recent scare that was caused by possible problems with ICICI Bank got the FM and the RBI to jointly vouch for the strength of the bank. This should make us stop and think. Are we really secure in a flattened world? And, in case things really went wrong what could be the consequences?
To the question as to how safe are our banks, there’s no clear answer. Nobody ever expected that the high growth in mortgages in the USA which were dressed up as securitised assets was actually an explosive waiting to be detonated. The fall of Bear Stearns and other investment banks was a result of something which went wrong which no one expected would go wrong, which is the case with all financial crises.
The RBI was prompt to get the banks to reveal their exposures to Lehman, but Lehman is just the tip of the proverbial iceberg. The fact that banks do take on large exposures in non-fund based activities is worrisome. When a bank lends money directly for a project, the risk is known. When it provides support to a derivative instrument or lends to another institution which has exposures to such instruments, then it loses that many degrees of freedom. In a quest to earn more non-fund-based ‘other income’ banks actually built up contingent liabilities which run into multiples of their own balance sheets, which is a concern.
However, there are other ticklish issues which have surfaced in the name of competition wherein banks have been chasing the customer to credit cards and mortgages. This was the route taken by several private banks to garner a greater share of the retail pie, as wholesale credit was not growing fast. Banks pitched for retail loans which looked good because they were small tickets and all could not default at the same time — but this did happen in the US which germinated the present financial crisis in the form of the sub-prime crisis.
Credit cards can be explosive as even today they are being provided indiscriminately to customers over the phone or outside the airport without any due diligence. These cards have spread quite swiftly increasing consumer spending and one is not sure about the defaults.
The message is that there are booms and busts for every phase of economic activity. It has been seen in manufacturing, in construction and there is no reason for it not to happen in the banking sector. That the RBI has been conservative has helped, but the regulator must monitor banks closely.
From the point of view of the deposit holder, the natural question raised is as to what would happen in case a bank went down under? If the bank was small, then the RBI could take care of it easily with a merger that took care of the depositors’ interest. But what could be done if a bank with a balance sheet size of Rs400,000 cr goes down? Deposit holders today are insured for Rs 100,000 and quite clearly, this needs to be enhanced. But here again the problem is that if say Rs250,000 cr of deposits have to be paid by the insurance company, where will the money come from? Secondly, a large bank cannot be merged with another one given the size involved — a failed large private bank might make another go down under the burden of the losses.
Given that there is no easy solution, the question of government participation in banks becomes relevant again. Public sector banks provide more confidence to deposit holders. Less than a decade ago Dena Bank, Allahabad Bank, United Bank and UCO Bank were in deep trouble — but no one withdrew their money because they are owned by the government.
However, a rumour regarding the stability of ICICI Bank started a run on the ATMs. It may make sense for the regulator to have a nominee on the boards of private banks (this may lead to several groans) so that someone responsible knows what is happening.
Commercial banking is a mundane business and as one is dealing with public money, the deployment of such funds must be judicious. Capitalism espouses creative destruction of institutions, but when the subject is banking it cannot be permitted. The only solution is to have strong prudential practices in place, and hope that things do not get out of control.

Eye See Eye See Eye: Financial Express: 21st October 2008

Traditionally, all banks tend to have imposing building structures because they have to give the impression of stability and reassurance to all their customers. Deposit holders in particular need to be told that their money is in safe hands. The most awe-inspiring building is the one built by ICICI Bank in Bandra Kurla Complex which is symbolic of size, dynamism and innovation.
The malicious campaign against ICICI Bank perhaps had roots in the bank’s success; a case of sour grapes. ICICI’s global forays were aggressive and accolades were won when the conquests were made. But this was turned into a fear factor by those talking about risks. The best thing is, of course, to always look at the numbers.
Quite coincidentally, RBI recently brought out data on banks. ICICI has witnessed a growth of 260% in its deposits and credit in the last four years. With a credit-deposit ratio of 92% (SBI peaked at 78% in FY08), it clearly shows the calibre of a leader. However, its cost of funds has increased from 3.02% in FY05 to 6.4% in FY08. Contrast this with SBI which has seen an increase from 4.9% to 5.64% during the same period. Quite clearly, the deposit garnering act has been at a higher cost.
On the earnings side, the adjusted return on advances (after adjusting for cost of funds) has fallen almost continuously from 6.94% in FY04 to 4.08% in FY07 before rising to 4.33% in FY08. Higher cost of funds (deposit) combined with lower returns does raise questions. One often quoted instance of aggressiveness is in the cards business where the Bank has one of the largest number of card holders—however, these cards are distributed quite freely outside Food Bazaar outlets or any other department store. This could be a source of concern as delinquencies can be high here if proper due diligence is not done. Again in contrast, the SBI’s return on advances actually rose from 1.88% in FY04 to 3.70% in FY08.
These numbers would not otherwise have been too significant but for the fact that the NPA ratio has also been on the rise. In fact, the Bank had prudently brought down this level post becoming a universal bank in 2003, from 2.21% to 0.72% in FY06. However, it has risen in the last 2 years to 1.55%. In contrast, the NPAs of SBI had come down from 3.48% in FY04 to 1.56% in FY07 before rising to 1.78% in FY08. ICICI Bank is well capitalised which is comforting as the ratio has risen to 13.97%, one of the highest in the industry. However, the fact that it has been raising capital in the past means that with this kind of financials, it may be difficult to do so more frequently. Its capital (equity plus reserves) has gone up from Rs 8,360 cr to Rs 46,820 cr during this period, while SBI was able to add only Rs 28,802 cr essentially through profit plough-back.
The other question raised about ICICI, and about banks in general, is their participation in financial ‘innovation’. Indian private banks and some public sector banks do have positions in off-balance sheet items that come under the heading of contingent liabilities. These business lines offer fee income without any accompanying deployment of resources and are therefore attractive. In case of ICICI Bank, the ratio of contingent liabilities to total assets was 2.87, while it was 4.45 for HDFC Bank and 2.36 for AXIS Bank. The same was 1.12 for SBI and 0.47 for Bank of Baroda. Everyone is taking a closer look at these business lines that provide a lot of ‘other income’ to banks and come under the scanner only under these unusual circumstances.
But the key question is: was there any reason for the layman, or deposit holder, to have got worried? The answer is obviously no because ICICI is very well capitalised and solid in terms of its functioning and losses if any can easily be absorbed. The fact that profits earned are over Rs 4,000 cr and that it has paid a dividend rate of over 100% this year are firm pointers of good performance and safety.

Back to the beginning: Hindustan Times, 15th October 2008

It is said that irony seldom escapes the characters in a drama. This is especially so when it is the financial stage where we all have our ‘entries and exits’. The way the financial crisis has unfurled, quite a few shibboleths of capitalism have been left shattered. The wiser ones describe the working of ‘capitalist greed’ as the ‘privatisation of profits and socialisation of losses’ — something that would rake up a turf war between Adam Smith and Karl Marx.
A significant aspect of the crisis is that we are all wiser after the event. Financial engineering threw up a lot of jargon — CDOs, CDS, securitisation, ABS, MBS etc. We never really figured out how they worked but all of us clapped when the off-balance sheet business multiplied to some $600 trillion, or 11 times the world output. The boom and bust of this business cycle is much like the now popular words of Nelly Furtado — why must all good things come to an end.
There are a few things that stand out from this crisis. One is that this is the first time in the last few decades that all the countries of the world have united for a non-political cause. So have the central banks — including China’s — to reduce interest rates across the board to assure the players that the government cares. The world now shares a common voice with two tones: one, rubbishing capitalism and two, doing everything to keep the world economy going while some countries like Iceland and Pakistan are slipping towards bankruptcy.
Both small and big institutions can fail without being noticed. But if the malaise is so deep that the entire edifice crumbles on failure, then one can be moderately sure of a rescue. If the US financial market goes under, so would the European, Japanese and other markets. The US maintained a stiff upper lip when Lehman Brothers crashed, which was out of place because when AIG went down a few days later, the parachute was opened.
Now everybody is suspicious of everybody else. Even lower interest rates have not encouraged banks to lend to one another, as no one is quite sure of the skeletons that may exist in another’s closet. In 2007, after Bear Sterns, it seemed that the worst was over. But along came the Freddie Mac and Fannie Mae sagas, followed by Lehman, Merrill and the rest. It will take time for this suspicion to die.
While India has been tom-tomming the fact that it was insulated from the crisis due to sound policies and practices, the recent scare related to a private bank has shown that no one is totally protected. The regulator assured us that overall bank exposures to Lehman were minimal. But then, Lehman is only the tip of the iceberg and the air of uncertainty now pervades the entire system as various other institutions around the world continue to crumble. How exposed are we to them?
With Goldman Sachs and Morgan Stanley now looking towards becoming regular commercial banks, the financial system appears to have come a full circle. Therefore, from being the hub of action and innovation, banking will go back to its ledgers and tellers.
Progressively, governments across the world will now be taking a stake in commercial banks. This is being done with a dual purpose. The first is to assure the public that their money is safe; the second is to keep a watch on the operations of the banks. This works well for the banks for, after the mess that has been created by them, the government can now be a part of the cleaning-up operations.
The move towards nationalisation and government support makes one nostalgic for the 70s-80s. And to think that those like Moodys, Standard & Poor, IMF and the World Bank have all been clamouring for more privatisation.